Wednesday, September 28, 2005

Over the past decade crude oil prices have increased from $12 (1998) to over $65 a barrel. However the attention paid to this price increase in misplaced, what is relevant is the wealth transfer from oil importing countries to oil exporting countries. The price paid by consumers in importing countries is different from the wealth transfers to exporting countries also due to government taxes in importing countries. The amount of net oil exported by importing countries is about 28 million barrels a day. With 1998 prices as a reference, this translates to an additional wealth transfer of $1.32 billion a day, or $480 billion a year. If the supply of oil is inelastic, then an increase in tax by the governments of importing countries would push up oil prices and decrease the wealth transfer. For a range of demand and supply elasticities that I study, the wealth transfer savings for the United States (which has about one-third of global oil imports) should be in the range of $108 to $152 billion a year. The new tax revenues to the US government from tax on imported oil should be $160 billion to $250 billion a year. This money can be returned to the US consumers as a lump sum so as not to increase the tax burden. This tax would also reduce consumption of oil leading to an alleviation of the problem of global warming. The major argument against climate change treaties (like the Kyoto Agreement) is that they would reduce economic activity. I show that, on the contrary, that a tax of crude that is returned as a lump sum payment to consumers would achieve a reduction in consumption of oil (to the benefit of the climate) and provide a huge stimulus to the economy. The reduction in crude oil consumption ranges from 7.13% to 10.30% while providing a stimulus (defined as additional purchasing power to consumers) to the economy of $95 billion to $133 billion a year.

The price of gas has certainly attracted a lot of attention in the real past. To understand why gas prices are so high, we need to look no further than the price of crude oil. The average crude prices were only an average of $12 in 1998, whereas recently they crossed $65 a barrel. This is an increase of over 441% over 7 years, and is the cause of gas prices reaching $3 a gallon. As a result of this the yearly oil bill for the US has increased by over $200 billion. And with China and India emerging as major new consumers of gas, the situation will only get worse with time.

This increase in price has not been driven by a corresponding rise in production costs. The cause of the high prices is rather the increasing demand combined with a inelastic supply of crude oil.

The consumers in oil importing countries today face a cartel of oil producing countries. This cartel has successfully raised prices of crude oil from about $12 a few years back to over $65 a barrel today. There seems to be an insufficient appreciation that the US consumer faces a producers’ cartel, which produces market conditions in which the effect of taxes do not work as they would in a competitive market. For example, consider a simple situation where the US consumption is only and all the output of OPEC. If the US government was to repeal the federal tax of $0.18 cents a gallon, while OPEC kept the production at the same level, it would result in no change in price paid by the consumer, only an increase of $0.18 per gallon in price received by OPEC. This aspect of the effect of taxing petroleum is missed by both those arguing for and against gas taxes (Mankiw 1999, Antonelli and Wilson 2000)

The OPEC cartel has been able to increase gas prices to its benefit, getting hundreds of billions of dollars of extra profit. It is precisely to stop this form of undeserved profits that the US has anti-cartel laws. However as the OPEC is composed of sovereign foreign governments, legally the US can do nothing, and indeed does nothing. So what can the oil importing countries like the US do? The answer is to form a buyers’ cartel that agrees to levy a tax on gas. Form an Organization of Petroleum Importing Countries (OPIC) to deal with the Organization of Petroleum Exporting Countries (OPEC). The members of OPIC would be the petroleum importing countries, US, Japan, China, India, and most of the European countries (Britain, Norway, Venezuela and Russia are significant oil exporting countries) among others. In today’s world the oil producers have banded together whereas the consumer is fragmented. Simple economic analysis of this situation points to the current outcome, hundreds of billions of dollars of wealth transfer to OPEC.

Supply, Demand, Wealth Transfers and Taxes

In this section I calculate the wealth transfers and effect of taxes for demand and supply for crude.

The price of crude is currently at around $65 a barrel and the worldwide average finding and production cost is $14.75[1]. With importing countries buying about 30 mbpd from the exporting countries, this corresponds to a wealth transfer of: ($65 - $14.75) x 30 mbpd = $1.51 billion a day = $550 billion a year.

The actual supply of oil is determined by complex factors, and obviously the estimates of this section are “rough”. In addition to the OPEC there are other countries that export crude. One factor in the supply of crude to the world market is determined by strategies followed by these countries who watch OPEC’s actions. OPEC members themselves break agreements they reach within themselves and over-produce. Major producers like Saudi Arabia claim to increase production when price increases, apparently to appease US demands. Still the supply of oil is relatively inelastic (especially in the short term) as the high price of the product relative to the cost of production encourages full production by non-cartelized producers, whereas cartelized producers seem to make token increases in production in response to price increases.

Recognizing that we do not have good estimates of the schedules I will makes estimates for four values of the slope of the demand schedule relative to the supply schedule. As we will see, the results remain broadly similar for the different relative slopes of the demand and supply schedule. So even though the number of data points used for the estimation are very small, we can have some faith in the results.

In reality, the slope of the supply schedule is probably more inelastic than the calculations of this section suggest. With the world average cost of finding and production at $14.75 per barrel and the market price at $65 a barrel, it is difficult to imagine any producer cutting back on production in response to a fall in price. It is indeed quite likely that some countries (especially those that belong to a production restriction cartel) would try to increase production to make up for a loss in revenue if price falls. If the supply schedule is indeed more inelastic than estimated in this section, it would make the conclusions of this paper even stronger. Greater the inelasticity of the supply schedule, greater is the share of a tax borne by producers.

To estimate the demand and supply schedules I make four assumptions: 1) The slopes of the two schedules are the same in magnitude; 2) The supply schedule remains the same over time except for the price being deflated by the increased cost of production. This assumes constant technology for the production of oil; 3) I assume existing taxes (which vary widely between countries) are incorporated in the existing supply schedule. 4) I assume that the demand and supply schedules for world production and consumption approximate the demand and supply schedules of oil-importing countries[2].

The model is solved using the crude prices in 1998 ($12 per barrel), in 2005 ($65 per barrel), the world consumption in 1998 (74 million barrels a day) and 2005 (28 million barrels a day).

Demand (D) and supply (S) are measured in million barrels per day, and price (P) in $/barrel. Let the demand and supply schedules in 1998 be given by:

D98=X-m * s * P98(1)

S98=Y+ s * P98(2)

An m of 0.5 implies that supply is relatively more elastic compared to demand. An m of 1, 2 and 4 correspond to increasing elasticity of demand with respect to supply. I estimate the effect of a 200% tax for these 4 values of m.

Let the demand schedule increase (right shift) by I in 2005. Also the price is deflated by the ratio of increase in the consumer price index (C) from 1998 to 2005 and demand increases (shifts right by I) from 1998 to 2005:

D05=X+I-(m x s x P05/C)(3)

Whereas the supply schedule remains the same except for the price being deflated by the ratio (R) of increase in finding plus production costs from 1998 to 2005:

Suppose a new tax of 200% is imposed. Then the demand schedule changes to:

D05-Tax=X+I- (s x m x 3 x P05-Tax/C)(5)

Where 3 x P05 is the price paid by the consumer while P05 is the price obtained by the producer. The supply schedule remains unchanged at:

S05-Tax=Y+ (s x P05-Tax/R)(6)

Solving (1) through (6) we will have the quantity demanded (and supplied) post-tax, and the new price per barrel obtained by producers, the new price per barrel paid by consumers (be price paid by producers plus the 200% tax), and the wealth transfer savings (wealth transfer at old prices minus wealth transfer at new prices). These values for the 200% new tax and four values of m = (0.5, 1, 2, 4) are presented in the table below. The wealth transfer savings to the US are calculated as the wealth transfer without the 200% tax minus the wealth transfer with the 200% tax. This fall in wealth transfer is primarily due to the fall in price which foreign producers obtain, and to a much lesser extent due to the fall in imports[6].

The stimulus to the US economy calculations assume that the government returns the new taxes on crude imports to the citizens as a lump sum tax[7]. The stimulus is defined as the tax (returned by the government to the consumers as a lump sum) minus the higher cost of gas due to the tax imposed (the new price obtained by consumers minus $65 pre-tax price multiplied by the new consumption amount).

Table 1

2005 Prices, Quantities, Tax Revenues to the US on Foreign Oil and Wealth Transfer Savings for the US due to Imposition of a 200% Tax on Crude Oil

Demand and Supply Schedules estimated using Price and Consumption Data from 1998 and 2005

m = 0.5

m = 1

m = 2

m = 4

Price to Foreign Producers (per barrel)

$36.92

$30.92

$26.85

$24.42

Fall in Price to Foreign Producers

42.30%

52.43%

58.70%

62.43%

Price to US Consumers (per barrel)

$110.75

$92.76

$80.54

$73.26

Increase in Price to US Consumers

70.39%

42.71%

23.91%

12.71%

Quantity Consumed (Million Barrels per Day)

78.01

76.73

75.86

73.26

Drop in Consumption of Crude

7.13%

8.65%

9.69%

10.30%

New Tax Revenues to the US Government on Foreign Oil (billions per year)[8]

$250

$206

$177

$160

Wealth Transfer Savings to the US (billions per year)

$108

$129

$144

$152

Stimulus to the US economy (billions per year)

$95

$114

$126

$133

As a check, the above process is repeated using data from 2003 and 2005 (rather than 1998 and 2005). The results are presented in Table 2. As may be seen, the drop in consumption, the wealth transfer savings, the stimulus to the US economy etc. are broadly the same.

Table 2

2005 Prices, Quantities, Tax Revenues to the US on Foreign Oil and Wealth Transfer Savings for the US due to Imposition of a 200% Tax on Crude Oil

Demand and Supply Schedules estimated using Price and Consumption Data from 2003 and 2005

m = 0.5

m = 1

m = 2

m = 4

Price to Foreign Producers (per barrel)

$37.29

$31.19

$27.02

$24.52

Fall in Price to Foreign Producers

42.64%

52.01%

58.43%

62.28%

Price to US Consumers (per barrel)

$111.86

$93.58

$81.06

$73.56

Increase in Price to US Consumers

72.09%

43.97%

24.70%

13.16%

Quantity Consumed (Million Barrels per Day)

79.07

77.94

77.16

76.70

Drop in Consumption of Crude

6.10%

7.44%

8.36%

8.91%

New Tax Revenues to the US Government on Foreign Oil (billions per year)[9]

$256

$211

$181

$163

Wealth Transfer Savings to the US (billions per year)

$106

$128

$142

$151

Stimulus to the US economy (billions per year)

$95

$114

$127

$135

Global Warming and Economic Stimulus

Over the past decades concerns have grown worldwide over global warming and climate change. The conventional wisdom is that an alleviation of this problem can only be obtained at the cost of lesser economic activity. As President Bush said prior to the recent G-8 summit “[Kyoto] was a lousy deal for the American economy.”

I show that a tax on gas that is returned as a lump sum to the consumers actually will provide a huge stimulus to the US economy. At first glance a new tax providing a stimulus seems paradoxical. However what happens with the tax is: 1) It transfers wealth from foreign producers (governments) to the US government. It is important to understand that the recent increase in crude prices is similar to the foreign governments taxing US consumers. 2) The US government returns this money to the US consumer as a lump sum (not ex-post based on their consumption of gas). This results in the US consumer having an increased spending power of $95 billion to $133 billion a year, giving the economy a major stimulus.

Conclusions

We see that for the range of slopes for demand and supply that we study, the introduction of the 200% tax causes the price per barrel received by producers falls to somewhere between $24.42 to $36.92 from the current $65. Similarly the US saves between $108 to $152 billion a year, while the extra purchasing power available to consumers creates an economic stimulus of $95 to $133 billion a year. Also the consumption of crude falls by an amount between 7.13% to 10.30%. The estimates of the demand and supply schedules in this paper are based on a very small data set, so the estimates are at best approximate. There is indeed reason to believe that the supply schedule is actually more inelastic, implying that the benefit of a gas tax to US (and other oil-importing countries) consumers is greater. The tax on crude offers important economic and environmental benefits and it is imperative that it forthwith be implemented.

[5] ibid Data available at constant 2003 prices have been inflated at 2.5% per annum

[6] Wealth transfer after taxes have been introduces is quantity imported multiplied by (Price – Cost). Cost is finding and production cost and is taken as $14.75 (ibid).

[7] It has to be a lump sum tax rather than a tax proportional to crude consumption. Or to minimize the redistribution effects may depend upon ex-ante (but not ex-post) crude consumption.

[8] This item is calculated as a 200% tax on imports. Quantity imported without taxes is assumed to be 10 mbpd. With taxes the quantity imported is assumed to decline at the same proportion as the decline in worldwide consumption.

[9] This item is calculated as a 200% tax on imports. Quantity imported without taxes is assumed to be 10 mbpd. With taxes the quantity imported is assumed to decline at the same proportion as the decline in worldwide consumption.